FDs, debt MFs & bond coupon are all taxable at marginal slab rate now.
Let us start with certain basic facts. While tax on your investments is important as the net-of-tax return is what you take home, it is not the major deciding factor. Investments are about suitability. There are ‘n’ number of investment instruments and investment vehicles; you have to pick the ones that suit you.
For instance, if there is a risky investment offering tax breaks but it is not suitable for you, you should not go for it. On the other hand, if there is a suitable investment taxable at your marginal slab rate, it is right for you. Having said that, let us look at the fixed income investment options.
Bank term deposits
The immediate reaction to the tax rule change for debt mutual funds was that bank term deposits are more attractive now. As we have discussed earlier, the banking system in India is sound. Interest rates have moved up, subsequent to rate hikes by the Reserve Bank of India (RBI). There is scope for bank deposit rates moving up gradually. Bank deposits are liquid, you can exit whenever you want. However, there is a premature withdrawal penalty. Not only that, the interest rate considered is the rate applicable for the time period for which your money was there with the bank, when making the deposit.
Debt mutual fund schemes
There are 16 debt fund categories, plus Target Maturity Funds. There are good portfolio credit quality funds, comprising government securities, state government securities, AAA- rated public sector and private sector bonds. Target Maturity Funds offer a good visibility on returns. Portfolio yields (the approximate rate at which interest accrues in debt funds) are much better now due to rate hikes.
Dividend (income distribution cum capital withdrawal) option was anyways taxable at your marginal slab rate. The recent tax change makes the growth option returns taxable as short term capital gains (STCG), irrespective of holding period. STCG is taxable at your marginal slab rate. This effectively takes away the indexation benefit, which was available till March 31, 2023, for a holding period of above three years.
The immediate reaction was that debt mutual funds have been disadvantaged. However, the correct perspective is that the advantage debt MFs had earlier is no longer there. Now, bank deposits, debt MFs and bond coupon (interest) — all are taxable at your marginal slab rate.
Fresh investments in debt MFs should be made in new folios. Reason is, redemption happens on First In, First Out (FIFO) basis and you want to avoid any issues on the tax benefit on investments made till March 31, 2023. A new folio will bifurcate old and new deployments.
There are corporate bonds issued by PSUs and private sector companies. There are multiple maturities available: short, moderate, long. You can choose your bonds as per your investment time horizon. You can pick multiple bonds of various maturities, which create an automatic cash flow.
When you hold a bond till maturity, you are effectively doing away with market volatility, as you get the return initially contracted. Bond coupons are taxable at your marginal slab rate. There is tax efficiency in the capital gains component of bonds, if you sell before maturity. For listed bonds, for a holding period of more than one year, long term capital gains are taxable at 10%, without the benefit of indexation.
Now the taxation of debt investment options will happen on the same platform, which is your marginal slab rate. Though it may seem that debt MFs have been ‘disadvantaged’ by taking away indexation benefit and bank deposits have been ‘advantaged’ on taxation, fact is, the platform is the same now. Dividends (IDCW) and growth option of debt MFs (taxable as STCG), bank deposit interest and bond coupon (interest) are taxable at your highest slab rate. Investors at lower tax brackets will be relatively better off, and ones at higher brackets will have to pay at their respective rates. But you execute your investments on merit now, not on taxation comparison.